Did you ever have one of those days when you can’t decide if you want to break something or cry? I had one of those days last week. I was expressing my view in an online forum that credible investing strategies begin with an idea, something that derives one way or another from the body of financial theory that tells us how sock prices are established. Another participant who favored the process of searching the data to see what worked in the past took the position that such factors could be used even without a determination that they relate somehow or other to core investment theory. He claimed “if you are creative enough, you can make up a theoretical basis for almost anything.”
#$([email protected]%! No! No matter how creative you are, you cannot make up a theoretical basis (of investing) for almost anything. Not even close! Well, actually, maybe I’m being a bit too broad. We’ve seen time and again how often investors do things that cause their savings to implode. But I’m taking it for granted that if you’re on this web site and took the trouble to click on this article, you’re not among them.
There are reasons why stocks are priced as they are. There’s nothing random about why Stock A may be priced at $20, Stock B at $4.83, and Stock C at $76.50. The reasons aren’t always easy to ascertain, and there is plenty of room for disagreement. But typically, if one person says Stock C is worth $76.50, another investor might say $70, another might say, $82, someone else might say $73.25, etc. But absent spectacular situations like Herbalife (HLF), nobody who knows what they’re talking about is likely to suggest $25 or $153.
And by the way, it’s not sufficient to brush the topic off by citing “supply and demand.” Any economist will tell you that neither supply nor demand exists in a vacuum and that there are reasons why they are what they are. So when I talk about stock prices being based on reasons, consider that a shorthand way of saying that there are reasons why supply and demand curves for a particular stock are such as to intersect at or near one price level rather than any number of others.
The theory is actually quite simple and completely firm. I’ll cover it all in this article and in just a few paragraphs.
The challenge is bridging the gap from theory to the real world, which I’ll do in subsequent installments. And by the way, this isn’t just for those who use fundamentals. Understanding stock pricing can even make the difference between successful technical analysis and technical analysis that doesn’t work. And by the time we’re done with this series, you’ll even understand why stocks like Tesla (TSLA) and Amazon.com (AMZN) are priced in the ranges you see.
Starting on Square One
To think about what a share of corporate stock is worth, we begin with the reason why the cooperation exists and what we, as shareholders, expect from it. Actually, we can back up a bit more than that. Why would anybody be in any business at all? Answer: To make money!
Forgive me if the next few paragraphs seem overly basic. But I need to do it because although we know this stuff, we tend to forget it as soon as we focus on the stock market. That’s unfortunate. We need to really stay anchored in this material.
In the most basic form of business organization, a sole proprietorship, it starts with revenue – the money you get from customers or clients. From that, you need to pay the expenses of the business (including, I assume, your own salary if you work in the day-to-day operations). Everything left over is yours; it’s your profit. Sole proprietors do tend to think of profit and owner’s salary as being the same thing. Since this is an informal kind of organization, it’s tolerable (although it doesn’t make for the best kind of tracking and analysis).
In terms of formality, the next step up is a partnership. Now, because there’s more than one owner, it is important to dot the “i’s” and cross the “t’s” lest the partners constantly be at each other’s throats over everything and anything. When a partner takes money out of the business (aside from a salary one gets for work done), it’s called a “draw.”
Corporations are like partnerships in that there’s typically more than one owner (we need not address the subtleties of single-owner corporations); often thousands or millions of owners. Now there’s a more formal gulf between the owners and the day-to-day business. In this setup, when an owner receives money from the corporation, it’s a dividend. In the world of publicly-owned corporations with which we’re concerned, most shareholders do not work for the business and, hence, do not get salaries, bonuses, 401K contributions, health insurance, or anything except for dividends. So dividends are important, very, very, very important.
The Theory of Stock Valuation: Simple and Ironclad
Therefore, nobody should be surprised when I say the value of your shares is determined by the present value (PV) of the dividends you get. How easy is that!
All you need to do is take an introductory finance class or look at a book and web site in order to learn what present value is. (For the uninitiated, if I guarantee to give you $100 one year from now, that would be the equivalent of getting $98.04 today if you can invest that money at an annual return of 2%. Hence the present value of the promise would be $98.04.)
So to value a share of corporate stock, all you need to do is sum up the present values of all the dividends you expect to receive in the future, and voila, we’re done.
